Amidst difficult economic conditions, Moody’s Investors Service has downgraded the outlook on Pakistan’s rating to negative from stable, and affirmed the B3 local and foreign currency long-term issuer and senior unsecured debt ratings. According to the agency, the decision to change the outlook to negative is caused by Pakistan’s heightened external vulnerability risk. Foreign exchange reserves have fallen to low levels and, without significant capital inflows, will not be replenished over the next 12-18 months. Low reserve adequacy threatens continued access to external financing at moderate costs, in turn potentially raising government liquidity risks.
It may be added here that a rating is Moody’s opinion of the credit quality of individual obligations or of an issuer’s general creditworthiness. Investors use ratings to help price the credit risk of fixed-income securities they may buy or sell. Moody’s decision to downgrade Pakistan’s rating from stable to negative B3 was anticipated given that these ratings are largely determined by a country’s external account position. Since the last fiscal year, Pakistan has been experiencing a constantly deteriorating current account deficit, to the tune of 16 billion dollars at last count, as well as a depleting foreign exchange reserve position with a 2.5 billion dollar loan repayment due next month.
Foreign indebtedness has reached an alarming 70 percent of Gross Domestic Product, according to the reported briefing given by the Ministry of Finance officials to the Caretaker PM, prompting Moody’s to note that unless capital inflows increase significantly foreign exchange reserves are unlikely to be replenished. Unfortunately, however, the hype created by the expected inflows under the China Pakistan Economic Corridor has not translated into significant Chinese disbursements with the State Bank of Pakistan revealing that foreign direct investment fell steeply during the past 11 months. Furthermore, any hope of shoring up the depleted reserves through the much touted Tax Amnesty on declaration of undeclared foreign assets seems to be fading because of the government’s inexplicable failure to notify the scheme and rules for the Bonds that are a part of the amnesty scheme and the most attractive option out of the three options available.
In the larger context, the last straw on the back of the economy is the fast eroding rupee value that had been shored up by the previous government’s constant interventions in the market. Claims by Ishaq Dar that abandoning the rupee to market conditions would lead to a massive erosion of the rupee value, a view that he stated on national television from his almost nine-month sojourn in London, reflect his understanding of the extent of the damage he did to the national currency through his flawed policies, including a focus on a deficit reduction, instead of balancing it with growth, encouraging borrowing by state-owned entities (SOEs) and allowing them to pass on the interest to the hapless consumers and productive sectors which, in turn, led to the inability of exporters to compete internationally. He also rigidly adhered to a policy of nepotism in appointments that led to sustained bleeding of the SOEs, and understated debt by redefining it, referring to debt equity as simply equity, and borrowing heavily from the banking sector abroad at high rates of interest and low amortization period.
Moody’s report comes as a blow to Pakistan because we are facing difficulty in taming a bulging import bill that is eating away at the country’s foreign exchange reserves. From almost $19.46 billion held by the State Bank of Pakistan in October 2016, foreign exchange reserves dropped 48.3% to $10.07 billion on June 8, 2018. The decline comes at a time when the import bill peaked to a record high of $5.8 billion in May, increasing the already swelling trade and current account deficits. The fragile external account position has already forced the SBP to let go off the Pakistani rupee that has now weakened over 15% in the last seven months after three separate rounds of devaluation.
But there is a silver lining to the cloud of economic gloom. According to Moody’s, Pakistan’s growth potential is considerable, supported by ongoing improvements in energy supply and physical infrastructure, which are likely to raise economic competitiveness over time. These credit strengths balance Pakistan’s fragile external payments position and very weak government debt affordability.
However, as experts have pointed out, continued growth in imports – driven by demand for capital goods under CPEC, higher fuel prices and robust household consumption – will prevent a significant narrowing of the current account deficit. Although exports have picked up since the start of 2018, growing around 10-15% year-on-year in US dollar terms, they only amount to half the level of goods imports. Unless capital inflows increase significantly, Moody’s does not expect official foreign exchange reserves to replenish from their current low levels. Under baseline projection, the import cover of reserves will likely fall to around 1.7-1.8 months during the current fiscal year, below the adequacy level of three months generally recommended by the International Monetary Fund.
Moody’s rating agency expects the government’s tax amnesty scheme, which expires in July 2018, to have a modest impact of around $2-3 billion in foreign exchange inflows. Secondly, the coverage by foreign exchange reserves of external debt payments due is weakening, pointing to further external vulnerability. With a significant rise in equity inflows unlikely, Moody’s projects that Pakistan’s external financing gap will be met by increased foreign currency borrowing. The outlook would likely be changed to stable if external vulnerability risks decreased materially and durably, including through policy adjustments that strengthen the external payments position.
There is a consensus among independent economists that the country is headed towards another International Monetary Fund programme, given the difficulties associated with borrowing from other sources at this juncture. Additionally, the decline in Moody’s rating would imply issuing sukuk/Eurobonds at well above the available market rate of return and heavy reliance on borrowing from foreign commercial banks. However, this time around the IMF conditions would be even more stringent than previously.